Particularly in the current, very dynamic phase of the VC world, one thing is clear to investors: no investment without downside protection. The anti-dilution clause is not the only must-have, but it is certainly an extremely relevant one from the perspective of venture capitalists. Founders and existing shareholders typically do not see this as a major risk. In fact, until not so long ago, downround protection provisions were more of a theoretical thought experiment. In the last 18-24 months, however, downround has proven to be a very real risk, with the corresponding consequences. What initially appears to be an understandable hedging instrument from an investor's point of view often turns out to be a real obstacle to financing in reality. The specific structure of the relevant regulation has an impact on the willingness of an external new investor to provide financing. Existing investors then also come under pressure: give in to the new investor's demands and waive the protection against dilution? Invest again themselves? Call their bluff with the risk of the investment collapsing? The following article serves as a guide to balancing the anti-dilution protection interests of investors with the interests of the company and new investors in an emergency.
Introduction - Downround scenario
The challenges that start-ups face in the course of their growth are diverse and unpredictable. For a variety of reasons, a financing round may not be carried out at a higher valuation but at a lower valuation than before ("Downround"). In this situation, the company is typically under high pressure. Fundraising is naturally challenging (otherwise it would not be a downround) and potential investors are making the shortening runway work for them.
In order to protect themselves from the effects of a downround, investors regularly demand downround protection provisions. This means that investors are granted additional shares at the nominal amount by way of a compensatory capital increase - to the exclusion of the other shareholders. In other words, they receive additional shares "almost as a gift" to compensate for the fact that they invested at a higher valuation at an earlier point in time. The amount of compensation depends on the specific form of downround protection.
From the perspective of a new investor, downround protection clauses make the investment less attractive for existing investors. The opportunity of a downround investment lies in acquiring as much equity as possible relatively "cheaply". However, compensatory capital increases for existing investors reduce the percentage share of the new investor in the share capital. The stronger the downround protection, the greater the deterrent effect.
Ultimately, investors who are supposed to benefit contractually from the downround protection regulation are also under pressure. If they were to waive their protection, this would significantly increase the likelihood of a deal. Otherwise, the new investor may jump ship or demand more on another level (e.g. disproportionate advantages in the liquidation preference or similar).
Getting the financing round over the finishing line in this situation is a balancing act that can be successful.
Common variants of Downround Protection
Full ratchet method
The full ratchet method is the most investor-friendly variant of the standard downround protection regulations. Under this method, investors receive the right to acquire as many additional shares at the nominal value as if they had acquired all shares at the lower downround valuation.
The equalisation effect is extremely high (100%). This situation is correspondingly demotivating for a potential new investor. Accordingly, it is rarely realised - even in the current market environment.
Narrow-based weighted average method
In practice, the narrow-based weighted average method is most frequently agreed. A weighted average price is calculated between the price at which the investor acquired shares in the past and the price per share of the downround. The investor is then treated as if he had invested at the average share price of both financing rounds.
Broad-based weighted average method
This is the most founder- and former shareholder-friendly variant. Similar to the narrow-based weighted average method, an average share price is calculated. Here, the share price of the downround is set in relation to the share price of all shares and other instruments such as option rights, VSOPs, etc. (quasi fully diluted). The equalisation effect is usually relatively low, meaning that the deterrent effect for new investors is relatively low.
The broad-based weighted average method is rarely used in practice.
Balancing act
In favour of financial viability in the event of a downround, founders and existing shareholders should take downround protection regulations seriously. In our experience, the narrow-based weighted average method has established itself as a sensible standard. The full ratchet method is - to put it bluntly - a sure way of preventing a financing round in a downround scenario and the broad-based weighted average method regularly fails to fulfil investors' need for security.
One possible instrument for adapting the effect of downround protection to the specific situation is to limit the duration of downround protection. If no downround has taken place in the next (and next but one) relevant financing round or within the next 12 or 24 months, this can be seen as a confirmation of the valuation with the consequence that the downround protection is then cancelled or at least reduced by a factor.
Another instrument is the introduction of a relevance threshold as a prerequisite for the applicability of the downround protection regulations. For example, the downround must be a financing round in which the company effectively receives at least EUR [●]. Anything less is not relevant for downround protection.
In practice, pay-to-play clauses have also proven to be useful. This means that the investor is only protected against dilution if he invests in the downround and fully utilises his subscription right. They must therefore invest as much as would be necessary in order not to be diluted by the new investment. It would also be conceivable to grant protection against dilution only on a pro rata basis, depending on how much is also invested. New investors regularly regard the follow-up investment by existing investors as a very positive signal, so that the deterrent effect of the anti-dilution clauses is partially mitigated.
Which measure or which combination of measures masters the balancing act depends on the individual case. It is important to know your tools and use them in each individual case. Then, even in a difficult downround, the balance of interests between founders, existing investors and new investors can be achieved.